Objectives of Financial Reporting - Wiley · Financial statements are designed to meet the objectives of financial reporting: Balance Sheet Direct Information Financial Position Statement

Focus on Basic Concepts - Module 7 1

Objectives of Financial Reporting

Financial statements are designed to meet the objectives of financial reporting:

Balance Sheet Direct Information Financial Position

Statement of Earnings and Comprehensive Income Direct Information Entity Performance

Statement of Cash Flows Direct Information Entity Cash Flows

Financial Statements Taken As a Whole Indirect Information Management & Performance

COPYRIG

HTED M

ATERIAL


Qualitative Characteristics of Accounting Information

Primary Qualitative Characteristics

Ingredients

Secondary Qualitative Characteristics

Relevance

Predictive value

Feedback value

Timeliness

Reliability

Representational faithfulness

Verifiability

Neutrality

Usefulness

Consistency& Comparability


Elements of Financial Statements

= Revenues _ Expenses + Gains _ Losses

Comprehensive Income = Net income ± Adjustments to stockholders’ equity

Assets _ Liabilities = Equity

Equity = _ = Contributions by owners

Distributionsto owners

ComprehensiveIncome

ComprehensiveIncome


Basic Rules & Concepts

Consistency

Realization

Conservatism

Recognition

Allocation

Matching

Full disclosure

You’ll get more credit (CR) if you CRAM your essays FULL of these rules and concepts

Focus on Basic Concepts – Module 7 5

Revenue Recognition

Accrual method Collection reasonably assured Degree of uncollectibility estimable

Installment sale Collection not reasonably assured

Cost recovery Collection not reasonably assured No basis for determining whether or not collectible

Installment Sales Method

Installment receivable balance Cash collections × Gross profit percentage × Gross profit percentage = Deferred gross profit (balance sheet) = Realized gross profit (income statement)

Cost Recovery Method

All collections applied to cost before any profit or interest income is recognized


Converting from Cash Basis to Accrual Basis

Revenues Cash (amount received) xx Increase in accounts receivable (given) xx Decrease in accounts receivable (given) xx Revenues (plug) xx

Cost of Sales Cost of sales (plug) xx Increase in inventory (given) xx Decrease in accounts payable (given) xx Decrease in inventory (given) xx Increase in accounts payable (given) xx Cash (payments for merchandise) xx


Expenses

Expense (plug) xx Increase in prepaid expenses (given) xx Decrease in accrued expenses (given) xx Decrease in prepaid expenses (given) xx Increase in accrued expenses (given) xx Cash (amount paid for expense) xx

Focus on Financial Statements – Module 7 8

Balance Sheet

Current Assets Current Liabilities Cash Short-term debt Trading securities Accounts payable Current securities available for sale Accrued expenses Accounts receivable Current income taxes payable Inventories Current deferred tax liability Prepaid expenses Current portion of long-term debt Current deferred tax asset Unearned revenues Long-Term Investments Long-Term Debt Noncurrent securities available for sale Long-term notes payable Securities held to maturity Bonds payable Investments at cost or equity Noncurrent deferred tax liability Property, Plant, & Equipment Stockholders’ Equity Intangibles Preferred stock Other Assets Common stock Deposits Additional paid-in capital Deferred charges Retained earnings Noncurrent deferred tax asset Accumulated other comprehensive income

Focus on Financial Statements – Module 7

9

Current Assets & Liabilities

Assets Liabilities Economic resource Economic obligation Future benefit Future sacrifice Control of company Beyond control of company Past event or transaction Past event or transaction

Current Assets Current Liabilities Converted into cash or used up Paid or settled Longer of: Longer of: One year One year One accounting cycle One accounting cycle

OR Requires use of current assets


10

Special Disclosures

Significant Accounting Policies

Inventory method Depreciation method Criteria for classifying investments Method of accounting for long-term construction contracts

Related-Party Transactions

Exceptions:

Salary Expense reimbursements Ordinary transactions


11

Reporting the Results of Operations

Preparing an Income Statement

Multiple step Single step Revenues Revenues – Cost of sales + Other income = Gross profit + Gains – Operating expenses = Total revenues Selling expenses – Costs and expenses G & A expenses Cost of sales = Operating income Selling expenses + Other income G & A expenses + Gains Other expenses – Other expenses Losses – Losses Income tax expense = Income before taxes = Income from continuing operations – Income tax expense = Income from continuing operations


12

Computing Net Income

Income from continuing operations (either approach)

± Discontinued operations

± Extraordinary items

= Net income

(Cumulative changes section was eliminated by SFAS 154)


13

Errors Affecting Income Error (ending balance) Current stmt Prior stmt

Asset overstated Overstated No effect

Asset understated Understated No effect

Liability overstated Understated No effect

Liability understated Overstated No effect

Error (beginning balance – ending balance is correct)

Asset overstated Understated Overstated

Asset understated Overstated Understated

Liability overstated Overstated Understated Liability understated Understated Overstated


14

Errors Affecting Income (continued)

Error (beginning balance – ending balance is not correct)

Asset overstated No effect Overstated

Asset understated No effect Understated

Liability overstated No effect Understated

Liability understated No effect Overstated


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Extraordinary Items

Classification as extraordinary – 2 requirements (both must apply) • Unusual in nature

• Infrequent of occurrence

One or neither applies – component of income from continuing operations

Extraordinary Negative goodwill on consolidation resulted from purchase (always) Acts of nature (usually)

Not Extraordinary Gains or losses on sales of investments or prop, plant, & equip Gains or losses due to changes in foreign currency exchange rates Write-offs of inventory or receivables Effects of major strikes or changes in value of investments


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Change in Accounting Principle

Use retrospective application of new principle: 1) Calculate revised balance of asset or liability as of beginning of period as if new principle

had always been in use.

2) Compare balance to amount reported under old method.

3) Multiply difference by 100% minus tax rate.

4) Result is treated on books as prior period adjustment to beginning retained earnings.

5) All previous periods being presented in comparative statements restated to new principle.

6) Beginning balance of earliest presented statement of retained earnings adjusted for all ef-fects going back before that date.


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Change in Accounting Principle (continued)

Journal entry: Asset or liability xxx Retained earnings xxx Current or deferred tax liability (asset) xxx

Or Retained earnings xxx Current or deferred tax liability (asset) xxx Asset or liability xxx


18

Special Changes

Changes in accounting principle are handled using the prospective method under limited cir-cumstances. No calculation is made of prior period effects and the new principle is simply ap-plied starting at the beginning of the current year when the following changes in principle occur:

• Changes in the method of depreciation, amortization, or depletion • Changes whose effect on prior periods is impractical to determine (e.g. changes to LIFO

when records don’t allow computation of earlier LIFO cost bases)

(Note: the method of handling changes in accounting principle described here under SFAS 154 replaces earlier approaches, which applied the cumulative method to most changes in ac-counting principle. SFAS 154 abolished the use of the cumulative method.)


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Change in Estimate • No retrospective application • Change applied as of beginning of current period • Applied in current and future periods


20

Error Corrections

Applies to:

• Change from unacceptable principle to acceptable principle • Errors in prior period financial statements

When error occurred:

Prior periods( Not presented )

Prior periodAdjustment

( Beginning ret. earn.)

Prior periods( Presented )

Adust Financial

Statements

Current period


21

Discontinued Operations

When components of a business are disposed of, their results are reported in discontinued op-erations:

• Component – An asset group whose activities can be distinguished from the remainder of the entity both operationally and for financial reporting purposes.

• Disposal – Either the assets have already been disposed of or they are being held for sale and the entity is actively searching for a buyer and believes a sale is probable at a price that can be reasonably estimated.

All activities related to the component are reported in discontinued operations, including those occurring prior to the commitment to dispose and in prior periods being presented for compara-tive purposes.


22

Reporting Discontinued Operations

Lower section of the income statement:

• After income from continuing operations • Before extraordinary items

Reported amount each year includes all activities related to the component from operations as well as gains and losses on disposal, net of income tax effects

• Expected gains and losses from operations in future periods are not reported until the fu-ture period in which they occur.

Impairment loss is included in the current period when the fair market value of the component is believed to be lower than carrying amount based on the anticipated sales price of the compo-nent in future period


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Reporting Comprehensive Income

Statement of Comprehensive Income required as one of financial statements

• May be part of Income statement • May be separate statement • Begin with net income • Add or subtract items of other comprehensive income

Other comprehensive income includes:

• Current year’s unrealized gains or losses on securities available for sale

• Current year’s foreign currency translation adjustments

• Current year’s unrealized gains or losses resulting from changes in market values of cer-tain derivatives being used as cash flow hedges


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Accounting for Changing Prices

Accounting at Current Cost

Assets & liabilities reported at current amounts

Income statement items adjusted to current amounts

• Inventory reported at replacement cost • Cost of sales = Number of units sold × Average current cost of units during period • Differences in inventory & cost of sales treated as holding gains or losses • Depreciation & amortization – Computed using same method & life based on current

cost


25

Accounting for Changes in Price Level

Purchasing power gains & losses relate only to monetary items

• Monetary assets – money or claim to receive money such as cash & net receivables • Monetary liabilities – obligations to pay specific amounts of money

Company may be monetary creditor or debtor

• Monetary creditor – monetary assets > monetary liabilities • Monetary debtor – monetary liabilities > monetary assets

In periods of rising prices

• Monetary creditor will experience purchasing power loss • Monetary debtor will experience purchasing power gain

Objectives of Financial Reporting - Wiley · Financial statements are designed to meet the objectives of financial reporting: Balance Sheet Direct Information Financial Position Statement

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